Cost of Debt

What is Cost of Debt (Kd)?

Cost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis, which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.

  • The cost of debt may be determined before tax or after tax.
  • The total interest expense incurred by a firm in any particular year is its before-tax Kd.
  • The total interest expense upon total debt availed by the company is the expected rate of return (before tax).
  • Since interest expenses are deductible from taxable income resulting in savings for the firm, which is available to the debt holder, the after-tax cost of debt is considered for determining the effective interest rate in DCF methodology.
  • The after-tax Kd is determined by netting off the amount saved in tax from interest expense.

Cost of Debt Formula (Kd)

The formula for determining the Pre-tax Kd is as follows:

Cost of Debt Pre-tax Formula = (Total Interest Cost Incurred / Total Debt )*100

The formula for determining the Post-tax cost of debt is as follows:

Cost of DebtPost-tax Formula = [(Total interest cost incurred * (1- Effective tax rate)) / Total debt] *100
Cost-of-Debt-Formula

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For eg:
Source: Cost of Debt (wallstreetmojo.com)

To calculate the cost of debt of a firm, the following components are to be determined:

Examples

You can download this Cost of Debt (for DCF Valuation) Excel Template here – Cost of Debt (for DCF Valuation) Excel Template

Example #1

For example, if a firm has availed a long term loan of $100 at a 4% interest rate, p.a, and a $200 bond at 5% interest rate p.a. Cost of debt of the firm before tax is calculated as follows:

(4%*100+5%*200)/(100+200) *100, i.e 4.6%.

Assuming an effective tax rate of 30%, after-tax cost of debt works out to 4.6% * (1-30%)= 3.26%.

Example #2

Let us look at a practical example for the calculation of the cost of debt. Suppose a firm has subscribed to a $1000 bond repayable in 5 years at an interest rate of 5%. The yearly interest expense incurred by the company would be as follows:

cost of debt example 1.1

i.e., the interest expense paid by the firm in 1 year is $50.  Savings on tax at an effective tax rate of 30% would be as follows:

cost of debt example 1.2

i.e., the firm has deducted $15 from taxable income. Hence the interest expense net of tax works out to $50-$15=$35. The post-tax cost of debt is calculated as follows:

cost of debt example 1.3

Example #3

For DCF valuation, determination of cost of debt based on the latest issue of bonds/loans availed by the firm (i.e., the interest rate on bonds v/s debt availed) may be considered. This indicates the riskiness of the firm perceived by the market and is, therefore, a better indicator of expected returns to the debt holder.

Where the market value of a bond is available, Kd may be determined from yield to maturity (YTM) of the bond, which is the present value of all the cash flows from the bond issuance, which is equivalent to the pre-tax cost of debt.

For example, if a firm has determined that it could issue semi-annual bonds of face value $1000 and a market value of $ 1050, with an 8% coupon rate (paid semi-annually) maturing in 10 years, then it’s the before-tax cost of debt. It is calculated by solving the equation for r.

Bond price= PMT/(1+r) ^1+ PMT/(1+r) ^2+…..+ PMT/(1+r)^n+ FV/(1+r)^n

i.e

The semi-annual interest payment is

Example 1.4
  • = 8%/2 * $1000
  • = $40

Putting this value in the above-given formula we get the following equation,

1050 = 40/(1+r)^1+ 40/(1+r)^2+…..+ 40/(1+r)^20+ 1000/(1+r)^20

Solving for the above formula using a financial calculator or excel, we get r= 3.64%

Example 2.2

So, Kd (Before -tax) is

Example 2.3
  • = r*2 (since r is calculated for semi-annual coupon payments)
  • = 7.3%

Kd (Post-tax) is determined as

Example 2.4
  • 7.3% * (1- effective tax rate)
  • = 7.3%*(1-30%)
  • = 5.1%.

The YTMYTMYield to Maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's expected returns after making all the payments on time throughout the life of a bond.read more incorporates the impact of changes in market rates on a firm’s cost of debt.

Advantages

Disadvantages

  • The firm is obligated to pay back the principal borrowed along with interest. Failure to pay back debt obligations results in a levy of penal interest on arrears.
  • The firm may also be required to earmark cash/FD’s against such payment obligations, which would impact free cash flows available for daily operations.
  • Non-payment of debt obligations would adversely affect the overall creditworthiness of the firm.

Limitations

  • Calculations do not factor in other charges incurred for debt financing, such as credit underwriting charges, fees, etc.
  • The formula assumes no change in the capital structure of the firm during the period under review.
  • To understand the overall rate of return to the debt holders, interest expenses on creditors and current liabilities should also be considered.

An increase in the cost of debt of a firm is an indicator of an increase in riskiness associated with its operations. The higher the cost of debt, the riskier the firm.

In order to make a final decision on the valuation of a firm, the weighted average cost of capital (comprising of cost of debt and equity) should be read along with valuation ratios such as Enterprise value and Equity value of the firm.

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